Inside the Fed

Let us open with this:  “It’s unlikely that the next policy rate move will be a hike. I’d say it’s unlikely,” – US Chair Jay Powell

This verbatim quote puts a lid on the movements seen in bond and interbank markets that might have overacted to recent data that has been above expectations and has led some to price hikes.

The let us counter that quote with this quote: “I think my expectation is that we will, over the course of this year, see inflation move back down. That’s my forecast. But I think my confidence in that is lower than it was because of the data that we’ve seen.” – US Chair Jay Powell

This ‘lack of progress’ is testing the board, it’s also clear that members are starting to get spooked by signs in the labour markets that employment is tight and starting to flex to the upside.

This is why we use the term ‘lid’ – the lid can come off and judging by the trade in the US500 and USD over the 2 hours from when the statement was released through to the end of Powell’s press conference, the lid is ajar.

The May meeting was supposed to be the start of the Fed’s march to lower rates.  At least that was what the pricing at the beginning of the year was telling us. As we’ve seen with the data; persistent inflation, strong employment, flat growth have clearly complicated where the Fed is now going. And the May meeting may be when the starter gun was lowered – signalling that the federal funds rate to remain at 5.25% to 5.5% for the foreseeable future.

If we look at the futures market the expected 150 basis points of rate cuts price in January, forecasted to start at the May meeting, now sits at a mere 32 basis point cut for 2024. And it’s falling further.

Risk on trading has been gorging on this idea since last October and in part explains why global indices have been so strong in the face of tough conditions. 

With the Fed in a fix about what to do next indices are now going to have to ‘prove’ (bottom-up fundamentals) that pricing is justified, something market is now testing.

On the FX front, the May Fed meeting has been taken in a different light. The lid has been taken as ‘firmly on’ and the USD has suffered for it.

DXY shows that across the pairs the USD was turfed out as those traders positioned for US Fed hikes got squeezed.

We need to be vigilant as to which pairs we looked at. Considering the EUR, GBP, CAD and Scandinavian currencies are likely to see rate cuts from their respective central banks in the coming months the current fall in the USD may be short lived here. But currencies such as the AUD and NZD facing higher rates for longer may hold on to the gains they acquired.

The conclusion, however, is that rates are on hold and will be higher for longer. The pressure this will put into risk assets is likely to be seen in the coming months and therefore a real test for the bulls that have been driving markets since October last year.